A
s discussed, analysis of the weekly COT data is extremely valuable in identifying markets with specific, unique characteristics based on the positioning of the participants. The commercials are often called the “smart money,” but they are only the so-called smart money at the major turning points. The day-to-day dominant market players and smart trading money tend to be the funds rather than the commercial hedgers.Commercial hedgers may be the most knowledgeable, but they are not the dominant force.
The commercial hedgers know certain things about the market that other traders, including the funds, do not know. The commercial hedgers are the most knowledgeable about supply and demand. That is why I call the commercial hedgers the knowledgeable money and the funds the smart money.
In previous chapters, I have also reviewed how I break the net- commercial category down into two entities that make up the net-commercial positions—I call these the commercial producers and commercial consumers. The producers are in the business of producing a particular commodity, whereas the consumers are in the business of consuming a particular commodity. Since these two entities are directly involved in the majority of the production and consumption, it stands to reason that they are the most knowledgeable about the supply and de- mand. We call this knowledge the fundamentals.
79 C H A P T E R 6
Plunger
80 COMMITMENTS OF TRADERS
NET-COMMERCIAL AND NET-FUND POSITIONS
I use the net-commercial position along with my statistical reference points (UCL/LCL and EUCL/ELCL) as my core trigger selection indicators.
When these reference points are penetrated, or when they are very close to being penetrated, it indicates that an unusual condition exists. We will only witness EUCL and ELCL penetration 0.27 percent of the time—it is a rare event. These unusual circumstances also correlate very strongly with the major turning points in the market; the unusual circumstances tend to lead the turns.
Further studies between historic price trends and size of the individual market participant positions reveal that once the size of the speculative (fund and/or large trader) market position has reached a certain threshold, the subsequent outcome (price direction) is much more predictable due to the inevitable unwinding of a large one-sided position. Once I identify a mar- ket that is exhibiting such a condition, I then focus on the price structure, price patterns, and price behavior to help identify the point in time that the unwinding is beginning to influence prices (meaning, it is beginning to act as the dominant influence in a sense). I often refer to the opposing fund posi- tion as the fuel for the trend. Sometimes this fuel burns evenly and consis- tently until the position is fully unwound and other times it burns more erratically, flickering on and off as if someone is purposely turning off the ig- nition and turning it back on. The result is a choppy directionless market.
The net-fund position can also be broken down further into its individ- ual components of long and short positions just as the net-commercial po- sition is broken down into commercial consumerlongs and commercial producershorts. When I break the net-fund position down, I simply break it into longs, shorts, and spreads. I have found that the more sophisticated funds tend to trade against the trends, and their positions are the most un- usual since the net-fund position as a whole tends to be a trend-following position. Thus, there are times when it is enlightening to monitor the op- posing fund position (which can be the long or short position, whichever is opposite of the current price trend).
In all cases, whether commercials or funds, the statistically unusually large positions tend to lead significant market turns. Once I identify a mar- ket that is exhibiting any of these unusual conditions, as defined by the size of the participant position and their orientation to the price trend, I then focus on the price structure. I begin employing traditional technical analy- sis along with pattern recognition analysis (including plunger patterns) to help identify the turn in the market so as to be positioned with a new trend.
I may see the net-commercial UCL/LCL penetration a week or several months in advance of the actual trend change. This always varies, which is
Plunger Patterns 81
FIGURE 6.1 Examples of forward plunger patterns.
why it is necessary to combine various technical tools with the COT indica- tors. These tools include pattern recognition, seasonal studies, and tradi- tional technical analysis. These tools, together with the COT indicators, enable me to both identify the upcoming move and to capitalize on it by cap- turing a portion of the new trend as it unfolds. I then enter and manage my position using my entry techniques, rules for managing risk and identifying the logical stops, and then the 50 percent rule and trailing stop methodology.
Let’s start by discussing plunger patterns. Plungers are one of the tools I use with the IMPA system. They are end-of-day price patterns that can be used as springs to enter larger IMPA setups or simple swing trades.
There are two types of plunger:
1. Forward plunger:May occur at or near short-term lows (sign of capit- ulation), and occasionally at major lows (see Figure 6.1).
2. Reverse plunger: May occur at or near short-term highs (sign of a blow-off high), and occasionally at major highs (see Figure 6.2).
FIGURE 6.2 Examples of reverse plunger patterns.
82 COMMITMENTS OF TRADERS
PLUNGER CRITERIA
The criteria for the daily plunger are that the market must meet or exceed a new 10-day high or 10-day low and then close in the opposite direction and in the top or bottom 30 percent of that day’s range. The entire price range for that day must also be at least one-third of an average day’s range for that market. This eliminates plungers with extremely small intraday ranges. The criteria for weekly plungers are essentially the same, except we evaluate the data on a weekly basis as opposed to a daily basis. Just as the close of each day is the most important price for a daily plunger pat- tern, the close on Friday is the most important price of the week for a weekly plunger. Daily plunger patterns, on average, are expected to pro- duce a short-term market reaction of one to three days. This is what I de- fine as the average yield of a daily plunger. The weekly plungers are a little trickier to evaluate, but overall their yield is essentially the same, except on a weekly basis instead of a daily basis. The best weekly plungers by far are the ones that are also embedded with daily plungers in the same direction.
A forward plungeroccurs when the market meets or exceeds its 10- day low and then reverses intraday and closes in the upper 30 percent of the day’s range. A market’s full range is 0 to 100 percent, with the low of the day corresponding to 0 percent and the high of the day corresponding to 100 percent. (Thus, a market that finishes on its high finishes at 100 per- cent and a market that finishes on its low finishes at 0 percent.) A reverse plungeroccurs when a market meets or exceeds its 10-day high and then reverses intraday and closes in the lower 30 percent of the day’s range.
APPLYING THE THREE-DAY RULE TO PLUNGERS
The market must follow through in the direction of the plunger pattern (up with a forward plunger or down with a reverse plunger) within three days following its formation. In the case of a forward plunger, the market must exceed the plunger day high within three days following the plunger; oth- erwise, the plunger expires. In the case of a reverse plunger, the market must exceed the plunger day low within three days following the plunger formation, or the plunger expires.
During the three-day period following a plunger formation, the oppos- ing plunger day high or low must not be exceeded on a closing basis. A for- ward plunger low must not be exceeded on a closing basis, just as a reverse plunger high must not be exceeded on a closing basis. If either occurs dur- ing the three-day period, the plunger is considered to have failed. It is pos-
Plunger Patterns 83
sible for a secondary plunger to occur within three days of the initial plunger formation. In that case, the new lows and highs of the secondary plunger pattern take precedence over the prior plunger day high and low.
APPLYING THE HIGH/LOW RULE TO PLUNGERS
The high and low that are put in the day a plunger pattern is formed are very important. In the case of a forward plunger, the low on the formation day becomes substantial support or what I refer to as the logical stop area (see following section). If this low is exceeded on a closing basis, the plunger is no longer valid. In the case of a reverse plunger, the high struck on the day the reverse plunger forms becomes serious resistance, and therefore a logical stop area. If that high is exceeded on a closing basis, the plunger will no longer be valid.
Another important signal is the failed plunger pattern. Plunger pat- terns that immediately fail indicate a potential trade in the opposite direc- tion. A forward plunger that immediately fails is often a good sell signal, and a reverse plunger that immediately fails is often a good buy signal.
TRADING WITH PLUNGER PATTERNS
As with any trading system, no pattern works 100 percent of the time.
Sometimes plungers will occur, and the market will move opposite to what we anticipated. This can happen with all identifiable price patterns and is normal. If it happens during the three-day period that a plunger is active, an opposing signal is created.
One of the benefits of identifying plunger formations and using them as entry points is that they provide logical stop protection. If a forward plunger identifies a turning point, then the low of the plunger should not be penetrated. If the market moves higher following a forward plunger day, the low of that plunger is the logical area to place a protective sell stop as you enter a long (buy) position (see Figure 6.3).
With a reverse plunger, the high of the plunger should not be pene- trated if the market is turning. The high of the plunger is the logical place for a protective buy stop as you enter a short (sell) position (see Figure 6.4).
You can take this stop placement a step further and use a stop close only type of protective stop. That means the market would need to close above or below the plunger day high/low to trigger the protective stop. The benefit of using this stop is that it allows you to avoid being stopped out on noise or other short-term fluctuations.
84 COMMITMENTS OF TRADERS
FIGURE 6.3 Stop placement on a forward plunger should be at the low of the plunger.
FIGURE 6.4 Stop placement on a reverse plunger should be at high of the plunger.
When a plunger pattern has been identified in a market, entry for the trade is easy to understand. As Figure 6.5 illustrates, a trader can enter a position as soon as the pattern is discovered, but must enter before a sig- nificant move has occurred. Additionally, the trade must be entered before the market turns back the other way, taking out the plunger high or low.
While trading on plunger patterns, I avoid buying or selling gap-opens or sharp moves immediately following this pattern. Market orders, limit or- ders, and stop orders can be used for entry.
Plunger Patterns 85
FIGURE 6.5 Plunger patterns can act as “springs” to enter the market, buying after a forward plunger is formed and selling after a reverse plunger.
Trade Examples
Figures 6.6 through 6.9 show examples of recent plunger patterns as recorded on our proprietary price graphs. These examples contain my notes and observations and were extracted from my evening reports to clients. I left these notes on the graphs because this information may be useful to readers of this book.
In the aftermath of the September 11, 2001, tragedy, the stock market fell precipitously. Although other factors, including a weakening economy and corporate scandals in the headlines, contributed to the decline in the equity market, the events of September 11 and the days immediately fol- lowing caused a sharp sell-off in stocks. The equity market would remain under pressure for months to come due mainly to economic factors, but Figure 6.6 shows how the immediate oversold conditions in S&P futures created a forward plunger that is also characteristic of a washout bottom.
Figure 6.7 shows a classic reverse plunger pattern (marked “X1”) in wheat futures, signaling a top had been put in the market. This sell signal was also confirmed by two other technical indicators, as the 10-day and 18- day moving averages (which lag the market) turned decidedly lower as well.
Forward and reverse plungers can also be dramatic, highlighting ex- treme overbought or oversold conditions at the point of a blow-off top (with a reverse plunger) or at the point of capitulation (with a forward plunger).
These patterns can occur just prior to a short-term change in the trend (or reversal) and sometimes longer-term as well. Consider the example in
86 COMMITMENTS OF TRADERS
Figure 6.6 S&P futures showing forward plunger in September 2001, indicative of a washout bottom.
FIGURE 6.7 Reverse plunger patterns in wheat futures.
Plunger Patterns 87
FIGURE 6.8 Washout or “puke-day plunger” shows dramatic bottom formed in the market.
FIGURE 6.9 Two forward plungers in S&P futures in July and October 2002.
Figure 6.8 of what is called a “puke-day plunger” in trader vernacular (also known as a “washout plunger”). These descriptive phrases tell exactly what is happening in the market: Traders are dumping positions to get out, regardless of price. Market activity not only reflects the current technical and fundamental factors, but also reflects the current emotional health of the market. Emotions such as euphoria and fear can be the cause
88 COMMITMENTS OF TRADERS
of the plungers. Fear can drive prices lower to the point of capitulation, which is where fear and greed meet!
Figure 6.9 shows two forward plungers in S&P futures, indicating buy setups. In Figure 6.9, notice the first forward plunger in July 2002 with the dramatic washout characteristics preceding the upward move that lasted through mid-August. The October 2002 forward plunger formed as the market retested the July lows. The plunger was less dramatic, lacking the same washout characteristics as the July forward plunger. That buy signal was also confirmed as the moving averages turned upward shortly thereafter.
Plunger Patterns and Stops
Plunger patterns can also provide an early entry point into an IMPA position trade. With a plunger pattern, you not only have an entry point, but you also have a stop that can provide a lower monetary risk on the initial entry. The reason is that the entry tends to be in close proximity to the stop, thus cre- ating a lower monetary-risk entry point versus a later-stage entry, which would occur when the price moved above the moving averages or the mov- ing averages crossed. These mature entry points tend to require wider stops versus the early entry points that the plunger patterns provide.
The mature entry points can be more reliable than the earlier plunger entries into IMPA-selected markets. The trade-off is lower monetary risk for less reliability. When the trade does work out, and if it is an IMPA se- lection, the profits from the successful trades will likely pay for the smaller losses on previous failed attempts to enter a market early on a plunger pattern.
Price Patterns
We pay attention to several classic price pattern formations when looking at price graphs. The following three patterns are helpful interpretative sig- nals to gauge the setup of a trend, as well as stop placement:
1. The “W” bottom:The “W” forms as the market puts in a bottom, trades higher, retests the low area, and then trades higher a second time. (See Figure 6.10.) This is a common characteristic in the soft commodities (such as sugar and cotton), as well as energy, grains, and stock indices.
2. The “V” bottom: This price formation occurs when a market trades lower and then reverses sharply. (See Figure 6.11.) This is a common characteristic in the livestock futures markets.
3. The “M” top:The third price formation is known as the “M” top, which is essentially the opposite of a “W” bottom. This pattern forms when
Plunger Patterns 89
FIGURE 6.10 W formation.
FIGURE 6.11 V formation.
the market puts in a high, then trades lower, retests the high, and then trades lower a second time. (See Figure 6.12.) The “M” top is common in many markets.
TRADE MANAGEMENT WITH STOPS
There are two basic environments in which to use a stop to manage posi- tion trades. The first is the initial phase and the second is the established phase of a trend.
The initial phase is the time that the market is potentially establishing a new trend. Volatility tends to be high as old positions (based on the old
90 COMMITMENTS OF TRADERS
trend) are being unwound and new positions (in the direction of the emerging trend) are being established. Because of these conditions, we typically need to have a wider stop, compared with later (established) phases when the trend is already in place.
As far as determining the specific placement of the stop during the ini- tial phase, if the new trend is emerging based on the IMPA criteria, I re- quire the price to close above/below the 18-day moving average for two consecutive days. During this initial phase, the stops need to be above/below contract high/lows, or an “X” day high/low (which could be the 10-day, 20-day, 50-day, and so forth, depending on the market condi- tions). If the monetary risk based on this stop placement is too high, a trader can elect to wait for a possible pattern to form, such as a plunger.
The plunger then provides a logical stop that is closer to the entry.
I stay with the initial stop until the new trend has been established.
There are several ways to determine when that has occurred (e.g., when the 10-day moving average crosses above/below the 18-day moving aver- age and both moving averages are pointing in the same direction). Once we are in an established environment, the purpose of the stop moves from loss containment to profit protection.
As the trade matures, and after a 50 percent profit has been taken, the position is managed using trailing stops. One way to accomplish this is to use the 2-day, 18-day moving average rule. In an uptrend, the stop would be placed below the 18-day moving average and would be activated if the mar- ket closed for two consecutive days below that level. In a downtrend, the reverse would occur.
Assume that the market closes above/below the 18-day moving aver- age for two consecutive days and you are stopped out of your trade. Now you are observing the market to decide whether a new opposing trend is emerging, or if it is possible to get back into the market once the existing FIGURE 6.12 M formation.